A Comparative Analysis of Auditor Independence in Economies in Transition

Pat Sucher and Katarzyna Kosmala MacLullich

Executive Summary

Auditor independence has for many years been seen as a crucial aspect of the credibility of the external audit function which, itself, is an important monitoring device of organisations, but it has been conceived in a predominantly Anglo-American context.

In recent years, as the requirements for companies to have an external audit have been implemented in economies in transition, the requirement for auditors to be independent has also been introduced into their national laws, especially in the context of European Union (EU) harmonisation and accession. It is, therefore, appropriate to research how a construct of auditor independence has been implemented in these economies in transition. An analysis of auditor independence in a different context from much of the Anglo-American research enables this topic to be reviewed from a different perspective. This project has been undertaken to investigate how the concept of auditor independence is perceived, and has been implemented, in two economies in transition: the Czech Republic; and Poland. A basic premise of this project is that auditor independence is not a single-faceted concept, but a multi-layered and complex construct that should, therefore, be analysed holistically. Some of the issues concerning auditor independence raised in this report are also relevant for developed market economies.

The research was undertaken between June 2001 and April 2002 and involved two stages. In stage one a framework of requirements for auditor independence was established building on the research of Sucher and Bychkova (2001). In order to seek a comprehensive understanding of what was happening in these transition economies, where the external independent audit may have been seen as a new concept, all aspects of auditor independence, from the basic educational provision for an auditor, to complex aspects such as the provision of non-audit services (NAS), were considered. From all of these aspects of independence, a framework of the requirements for independence was developed and is discussed in chapter three.

This stage of the research consisted of describing the economic, social and historical context for auditor independence in Poland and the Czech Republic and compared the current legislative and institutional frameworks for auditor independence in Poland and the Czech Republic; the de jure case. Any differences between the initial framework and the country's statutory regulations were identified as issues and formed the second stage of the research

In stage two, semi-structured interviews regarding auditor independence were undertaken in both countries with: auditors; preparers; users of financial statements; academics; and standard setters. The local professional press was also reviewed for any coverage of issues of auditor independence. The interviews were designed to ascertain how the concept of auditor independence was perceived and how the processes for implementing and monitoring auditor independence operated in practice; the de facto case.

Findings

De jure analysis: country comparisons

Overall, there was a similarity in the path that both the Czech Republic and Poland had taken for dealing with auditor independence. In both countries, Chambers of Auditors had been established (Czech Republic 1992; Poland 1991) and all auditors had to be members of their respective Chambers. Chambers were responsible for the education, training, discipline and quality control of their auditors. An initial cohort of auditors, trained under the communist regime, but not necessarily subject to the new examinations, were also brought into each Chamber. In both countries this group of auditors formed the vast majority of current registered auditors.

There were a number of similarities between the Czech and Polish Codes and the IFAC 1 Code (1999) regarding independence, in areas such as having direct financial interests, the percentage of fees from individual clients and the provision of goods and services. The Czech Code, however, included fewer requirements from the IFAC Code than the Polish Code. In both countries, however, the provisions in their Codes of Ethics were being revised to bring them into line with the new independence provisions in the IFAC Code of Ethics 2001.

Other de jure similarities between the two countries were in such areas as the requirement for audit standards, the education of, and assessment in, these standards and the necessity for legal liability insurance. Many of these similarities followed from the way in which both countries, as accession countries to the European Union, had sought to conform to the European Eighth Directive.

De jure and de facto implementation

From the interviews reported later, there was evidence that the societal, cultural and economic pressures, which might be threats to auditor independence in transitional economies, far outweighed any formal safeguards, either to maintain professional competence or to follow regulations on the provision of other services. Although there may be disciplinary mechanisms to ensure that all the regulations are followed, there are substantial issues in applying these enforcement mechanisms within the current immature legal framework and local traditions in accounting. These aspects appear to have had the most effect on the capacity of auditors to be independent.

In both countries there were issues of severe economic competition among auditors, an immature legal system, strong influence of taxation on financial reporting and low levels of enterprise liquidity, all of which could have a substantial impact on auditor independence. In both economies a large proportion of qualified auditors were from the Communist regime, who did not have the necessary training in existing, originally Anglo-American, standards of auditing. However, there were requirements for continuing professional education in both countries and this may help to deal with this problem in the future. There appeared to be a significant difference in the presence and press coverage of local auditor scandals. In the Czech Republic there has been quite extensive coverage of audit failures. Most of this coverage has related to the audit of large Czech banks by local Czech audit firms and the Big Five 2 audit firms. The lack of transparency that arose with the privatization of Czech banks in the economic recession of the mid 1990s, resulted in some banks being forced into liquidation. Some of these banks went into liquidation with unqualified audit reports. However, there has been far less coverage of similar issues in the Polish press. There were indications that, within the difficult economic environment, the local culture might have an impact on the ability of auditors to be independent. In particular, the emphasis on individual independence, comradeship and a rules-based approach to auditor independence in Poland could undermine the capacity for auditors to be independent. In the Czech Republic, the emphasis on the economic and rule-determined basis of auditor independence, allied with an adaptive approach to regulations and an emphasis on loyalty to friends and family, might mitigate against the problems of auditor independence. Issues for consideration for policy makers Enforcement To establish a new institutional framework for auditor independence in the Czech Republic and Poland, it is important to have a strong, believable, enforcement mechanism that builds up trust in the audit process among users of financial statements, where there should be an emphasis on providing resources for the regulatory mechanisms, such as the Supervisory and Disciplinary Commissions, to ensure that they can enforce the regulations. Although independence requirements based on the November 2001 conceptual approach of IFAC might be possible in these countries, if supported by adequate training, the implementation of independence would be enhanced if detailed examples of what undermined auditor independence were provided in a developing market context.

This requires the commitment of auditors to an enhanced legal capability in the transition economies, with properly functioning courts of law, and trust in the justice system for being equally accessible to a lay person, so that actions can be properly pursued through the courts. Economic competition Given the opacity of the quality of an audit to outside investors, it is likely that many users of financial statements are likely to continue to use the size of the audit firm as an indicator of quality. Size means predominantly what is now the Big Four, where the large international consortia of audit firms, are seen as offering a higher quality of audit compared with local audit firms. The issue of NAS is of a different order in smaller local audit firms than in the Big Four audit firms. With the Big Four audit firms, it may seem appropriate, at least, to disclose in the enterprises Annual Report how much is paid as audit fees and how much as other fees, for users to assess the implications. A tougher issue is ensuring that auditors act in the public, rather than their own private, interest with or without the provision of excessive NAS. The rotation of audit partners within an audit firm may be an appropriate control as well as closer governmental supervision of auditors, such as the closer regulation of the Chamber of Auditors in Poland and the Czech Republic by a government department. This may be feasible, as there is a long tradition of state interventionism in the accounting profession in this part of the world. Cultural context Western accounting knowledge in the form of best practice is a key theme in EU institutions and throughout their supporting legislative structures. This kind of approach has been imposed on developing markets through the harmonisation of national laws and practices with the requirements of the EU Directives. As a result, patterns of conduct, based on Western ideas in terms of best practice, travelled to the Central and Eastern European (CEE) region without the recognition that there were differences in local culture and accounting traditions and that professional ethics were historically constructed by other sets of concerns. New levels of perceived normality have been established for professionalism without reference to any cultural constructions within the CEE. Conclusions on the readiness for the accession of associated countries have been determined according to Western European political ideas. The framework for audit independence may be developed as a template to facilitate a dialogue between Europe and the accession countries, to establish what constitutes perceived normality in professional conduct and to define an appropriate time span to bring such conduct into line (as far as possible) with EU requirements.